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Cisco (NASDAQ:CSCO) reported last week relatively solid third-quarter results. The company reported third-quarter per share earnings of $0.48, an increase of 21% over the same period last year. This is a penny ahead of Wall Street estimates. Despite these good results, investors were cautious on the company's outlook after its CEO John Chambers said that the uncertainties surrounding Europe will have an impact on the company's performance moving forward.

Research firm Gartner has recently published that it has downgraded its global IT spending to 2.5% from previous estimates of 3.7%. With the U.S. and European economies still on shaky grounds, IT spending of government and companies will remain weak. CEO Chambers confirmed this with fourth-quarter estimated earnings per share of 44 to 46 cents, lower than consensus estimates of 49 cents. He also acknowledged that it is hard to speculate what would happen in the next 6 months for the global economy. The silver lining is that Cisco's clients have stated that they are going to increase their technology spending for the next 6 months. It appears that the market is not convinced that this will be the scenario for succeeding quarters.

Two Scenarios for Cisco

There are actually two possible scenarios for Cisco. The first scenario is the worst-case scenario. Government and corporate IT spending will not pick up any time soon. Competitors such as F5 Network (NASDAQ:FFIV) and Juniper (NASDAQ: JNPR) will gradually take over market share in the space it competes. It will also continue to lose market share to Hewlett Packard (NASDAQ: HPQ) and Dell in the enterprise router business. On the flip side, the second scenario is a base case scenario. Cisco will continue its dominance in network switches and services, as well as routers. It will also continue to beat Wall Street estimates even though there is no clear resolution in the European crisis.

At the current price of Cisco, investors do not believe that the second scenario will happen. If we assume that the first scenario will play out, we need to dig deeper whether Cisco has enough cushion for this. From a fundamental perspective, Cisco is sitting on net cash of $32 billion and generates $11 billion of annual operating cash flow. This means that even if Cisco does not earn a penny from its operations, it will still survive for the next 27 years with working capital and capital expenditure requirements of $1.2 billion a year.

However that scenario is not likely to happen unless a superpower declares global warfare. The bast-case scenario will most likely play out for Cisco. Cisco will continue its dominance in the router business, notwithstanding that other competitors are doing their best to grab its share. My thesis is that existing clients will continue to have loyalty for Cisco's products as they would not risk switching to unfamiliar products for their networking needs. The competitors will have to target the new clients to be able to grab market share.

Over the long run IT spending will be higher. The relatively flat growth for this sector for this year appears temporary. IT infrastructure needs will be complex in the future. Cisco has taken steps to capture the future potential. A good example was its announcement of its intent to acquire NDS group, a provider of content streaming and security software that will expand its next generation video services.

With this scenario, sales are expected to grow at 6% a year for the next 5 years. There was news that Dell is planning to offer lower prices for its router to gain market share from Cisco. Profit margins could be lower at 15% to 17% assuming that competition will intensify and add pressure to its margins. This will translate to free cash flow of $7 billion assuming that capital spending remains constant at $1 billion. Conversely its competitors have the same expectations. Sales of Juniper will grow at 4% over the next 5 years and profit margins at 7%. However, F5 network has better prospects. Its sales are expected to grow at 19% for the same period. Profit margins for F5 are also higher at 20%.

Mr Market not paying for Cisco's growth

The current market valuations for Cisco discount the company's future prospects. The stock is currently trading 9 times 2012 earnings and carries a dividend yield of 1.90%. Excluding net cash, the stock will be trading at 5 to 6 times earnings. In contrast, Juniper trades at 20 times 2012 earnings. Also F5 Network is valued at 24 times 2012 earnings. Its competitors are valued higher despite reporting profit declines in their latest earnings report.

Mr Market is not ready to pay up for the company's future growth. In fact, it believes that sales will decline over the next 5 years. Around 1% of its market float is short. This means that the declining stock price is not a case of distressed sellers, but the absence of strong buyers. Investors agree that shares are undervalued but they are not convinced that it will turn its operations around. You will notice that the financial media has been saying that shares are undervalued for several months now. Yet the stock price has gone cheaper every time the company reports slower outlook on the next quarter.

It's OK to be contrarian this time

One of the major concerns for investors is the company's ability to execute its plan to turn around its operations amid a tough operating backdrop. The latest quarter report showed that expenses as a percentage to sales are low. Also its earnings growth is a testament that the restructuring efforts are starting to pay off. CEO John Chambers has cut jobs and closed operations that were not related to the core business. This reaffirms my view that the turnaround at Cisco is very possible. It's definitely fine to be contrarian, especially when you're paying for zero growth for a company that has better future economic prospects.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Cisco: A Cheap Stock To Buy Before Coming Turnaround